traditional pension plans in the US: trouble (ii)

The California Public Employees’ Retirement System (CalPERS) is a bellwether for government employee pension plans around the US.

not fully funded

By its own calculations, CalPERS is not fully funded, meaning that it does not have enough money on hand today to meet the future pension obligations of its members. That’s even assuming, as it officially does at the moment, that it can earn on average 7.5% on its investments yearly.

assuming a 7.5% annual return

How reasonable is it, though, to think that CalPERS–or anyone else in a similar situation–can earn 7.5% on a diversified portfolio of stocks and bonds?

reasonable?

Let’s assume an asset allocation of 50% stocks and 50% bonds, just to make the arithmetic simple.

—bonds first. Let’s say that the yield on Treasure bonds rises to 4% over the next several years and stays steady at that level from that point on. When we’re there, CalPERS can earn the coupon each year by holding them, or 4%. A 4% return on half the portfolio is a contribution of 2% to the entire portfolio Note: we already know that the return will be less than that over the time it takes for interest rates rise back to normal.

—stocks. To achieve a 7.5% return on the entire portfolio, assuming bonds deliver 2%, stocks will have to chip in 5.5% per year to the total. This means achieving an average 11% annual return on the stock half. How reasonable is this? Well, over the past ten years the S&P has risen by 58%, or on average by a little less than 5% per year. If we assume that inflation will remain contained at around 2%, an 11% return would be a whopping 9% real annual return. Over long periods of time, stock markets around the world have averaged at best a 6% real annual return.

change the asset allocation?

Yes, we could up the overall return by shifting the asset allocation away from bonds and toward stocks. But the stock portion would have to be above 90%–making calPERS’ assets vulnerable to wide business cycle swings in their value–before it could achieve a 7.5% annual return, assuming a 6% real return on stocks.

In short, the numbers don’t add up. The biggest issue isn’t CalPERS’ ability, or lack of it, to manage money well. It’s that the actuarial assumption of future returns is too high.

Over the recent decade or more, pension plans like CalPERS have tried the “magic” solution of alternative investments–hedge funds and private equity–to try to square the circle. But most hedge funds continually produce returns to clients that are below the S&P 500. And, again, the allocation to such dubious, and illiquid, vehicles has got to be very large to move the total return needle, even if one believed the promoters’ marketing claims.

changing the actuarial assumption

Interestingly, California has just announced that it is going to accelerate the process of lowering the assumed return on CalPERS investments to what sounds like a target of 6.5%. To me, this is clearly the right thing to do, and the sooner the better. But it will also show that CalPERS is more deeply underfunded than today’s official figures suggest. It will likely mean that state and local governments will have to up their contributions to the fund.

That’s doable for California. But what about the country’s government pension fund basket cases, like Illinois and New Jersey? Following suit will show voters for the first timethe reality of how bad the situation is there.